Patagonia, Inc. was founded in May, 2000 by Lawrence Rollins, who was employed for the last 20 years as a river

rafting guide. Mr. Rollins received an unexpected inheritance of $2,000,000 in January, 2000. Soon after, he

decided to leave his lifelong career in river rafting and use his inheritance as seed capital for Patagonia. During the

first few years of its existence, Patagonia experienced steady sales growth, although the company has only recently

shown positive net income.

It is March, 2016 and the company is considering two alternative processes for manufacturing inflatable tubes to

service demand in a rapidly growing market. Management intends to make the initial investment in the project at the

end of April, 2016 and expects any cash flows associated with the project to arrive yearly, beginning at the end of

April, 2017.

The first manufacturing process has a higher start-up cost than the second, but greater economies of scale. The

expected cash flows associated with this process are presented below in Table 1.

Table 1:

Cash Flow Projections for Process 1

0 1 2 3 4 5

EBIT 250,000 400,000 460,000 400,000 400,000

Depreciation 200,000 200,000 200,000 200,000 200,000

Initial Investment (1,000,000)

The second manufacturing process requires a smaller initial investment than the first, and because of this it is

appealing to some members of the board. The expected cash flows associated with this process are presented in

Table 2 below.

Table 2:

Cash Flow Projections for Process 2

0 1 2 3 4 5

EBIT 733,333 400,000 291,667 66,667 66,667

Depreciation 160,000 160,000 160,000 160,000 160,000

Initial Investment (800,000)

The marginal tax rate for the company is 40% and after careful assessment of the risk associated with this project,

you conclude that the appropriate cost of capital for both processes is 9.75%.

At the initial presentation, project leaders of both teams presented their cash flow projections. However, since the

processes are mutually exclusive, the firm can only accept one proposal.

You have been asked to evaluate the two production processes and present your findings to the board of directors.

Your CEO Charlie, a loyal WORKER, learned good capital budgeting techniques in his finance classes at XXXXX,

and you are confident that he is able to distinguish among competing investment decision rules and use the

appropriate criteria for decision-making. However, the founder and Chairman of the Board, Lawrence Rollins, has

never taken a finance class. In fact, he is a self-made man who does not have a college degree. He prefers the second

process because it costs less money up-front. In addition, several influential old-timers on the board are intrigued

with the payback decision rule. It is your job to compute several decision metrics, clearly articulate the relative

merits of each, and make a recommendation to management about which process is preferred.

1. Compute the Net Present Value, Internal Rate of Return, Incremental IRR, Profitability

Index, Payback Period, and Discounted Payback Period for each of the two processes. Fill in the table below

with your answers and include it as Exhibit 1 of your report. Be sure to include a discussion of your

computations in the text of your report and provide additional exhibits to show all of your intermediate steps.

Process 1 Process 2

Net Present Value (NPV)

Internal Rate of Return (IRR)

Incremental IRR

Profitability Index

Payback Period

Discounted Payback Period

2. Which process would management choose if they used only payback as the decision criteria?

What argument(s) would you make to convince the board that the payback period is not an appropriate decision

rule? Should the board use discounted payback as the deciding factor? Explain why or why not.

3. Which process would management choose if they used IRR as the decision criteria? What arguments would you

make to show the board that the IRR measure could be misleading in this case? Is the modified IRR a helpful

measure in this case? Explain why or why not.

4. Explain the meaning of the incremental IRR. Based on the incremental IRR, which process should you choose?

Should the board use incremental IRR as a decision rule? Explain why or why not.

5. Plot the NPV profiles for the two projects and present the graph as an Exhibit in your report (see figure 5.6 on page

153 of the RWJ text for an example of how to do this). Explain the relevance of the crossover point. How would you

convince the board that the NPV method is best?

6. Is the profitability index helpful in this case? Explain why or why not.

7. If for some reason the management of Patagonia, Inc. is able to extend the life of process 2 for an extra year (Year 6)

and have an EBIT of $100,000 would your decision based on NPV change? What argument(s) would you make to

convince the board that the total NPV is not an appropriate decision rule anymore? Should the board use the

Equivalent Annual Cost (also known as Annual NPV) as the deciding factor? Explain why or why not.

Hint: Read page 193 Investments of Unequal Lives: The Equivalent Annual Cost Method in the textbook.

Table 2 for Questions 7:

Cash Flow Projections for Process 2

0 1 2 3 4 5 6

EBIT 733,333 400,000 291,667 66,667 66,667 100,000

Depreciation 160,000 160,000 160,000 160,000 160,000 -

Initial Investment (800,000)